**Walter’s Dividend theory**

Professor James E. Walter argues that the choice
of dividend policies almost always affects the value of the enterprise. His
model shows clearly the importance of the relationship between the firm’s
internal rate of return (r) and its cost of capital (k) in determining the
dividend policy that will maximise the wealth of shareholders.

Valuation Formula and its Denotations: Walter’s formula to calculate the market price
per share (P) is:

P = D/k +
{r*(E-D)/k}/k, where

P = market price
per share

D = dividend per
share

E = earnings per
share

r = internal rate
of return of the firm

k = cost of
capital of the firm

Explanation: The mathematical
equation indicates that the market price of the company’s share is the total of
the present values of:

a) An infinite flow of dividends, and

b) An infinite flow of gains on investments from
retained earnings.

The formula can
be used to calculate the price of the share if the values of other variables
are available.

*Walter’s model is based on the following assumptions:*

a) The firm
finances all investment through retained earnings; that is debt or new equity
is not issued;

b) The firm’s
internal rate of return (r), and its cost of capital (k) are constant;

c) All
earnings are either distributed as dividend or reinvested internally
immediately.

d) Beginning
earnings and dividends never change. The values of the earnings pershare (E),
and the divided per share (D) may be changed in the model to determine results,
but any given values of E and D are assumed to remain constant forever in
determining a given value.

e) The firm
has a very long or infinite life.

*Criticism of Walter’s theory:*

Walter’s model is quite useful to show the effects of dividend
policy on an all equity firm under different assumptions about the rate of
return. However, the simplified nature of the model can lead to conclusions
which are net true in general, though true for Walter’s model.

**The criticisms on the model are as follows:**
1. Walter’s model of share valuation mixes dividend policy with
investment policy of the firm. The model assumes that the investment
opportunities of the firm are financed by retained earnings only and no
external financing debt or equity is used for the purpose when such a situation
exists either the firm’s investment or its dividend policy or both will be
sub-optimum. The wealth of the owners will maximise only when this optimum
investment in made.

2. Walter’s model is based on the assumption that r is constant.
In fact decreases as more investment occurs. This reflects the assumption that
the most profitable investments are made first and then the poorer investments
are made.

**The firm should step at a point where r = k. This is clearly an erroneous policy and fall to optimise the wealth of the owners.**
3. A firm’s cost of capital or discount rate, K, does not remain
constant; it changes directly with the firm’s risk. Thus, the present value of
the firm’s income moves inversely with the cost of capital. By assuming that
the discount rate, K is constant, Walter’s model abstracts from the effect of
risk on the value of the firm.